Improved Growth Momentum Raises Chance of Turn in Equity Cycle

The flow of global growth statistics has been unimpressive by historical standards but recent numbers hint at the first signs of progress along an adjustment path leading to stronger raw material demand.

At the beginning of this week, Japan's Cabinet Office reported a third consecutive quarter of expanding GDP. Over the last 20 years, Japan has battled to get more than four successive quarters of growth. It has only managed to do this once - between March 2005 and June 2006 - when the quarterly growth rate averaged just 0.5%.

At the beginning of August, the Department of Commerce reported that US GDP had risen by 0.4% in the June quarter, slightly less than the 0.5% average quarterly rise since the US exited a recession in 2009 but better than the flat outcome as recently as the December quarter of 2012.

A week earlier, the UK government had reported a second consecutive quarter of GDP growth (+0.6%) marking just the third quarter of expansion out of the past seven.

Anyone interested in viewing charts of the historical growth outcomes can do so at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm.

During this week, Germany and other member countries of the EU are also slated to release June quarter output numbers with German growth predicted to exceed 0.6% which, if realised, would imply the strongest growing quarter since the beginning of 2011. The Euro area as a whole is expected to have expanded for the first time since late 2011.

Although inevitably less credible, Chinese statisticians put their growth in the June quarter at 1.7%. While high by the standards of others, this result sits at the low end of the range of outcomes political leaders have deemed acceptable.

From one perspective, the flow of statistics makes for bleak reading. Nearly everywhere, the pace of growth is slower than its potential and short of what governments would regard as tolerable. The International Monetary Fund (IMF) is now forecasting global GDP growth in 2013 of 3.1% compared with the average growth rate over the 10 years before 2008 of 4.0%.

Mainstream forecasters are generally predicting something better to come. The IMF, for example, is thinking of 3.8% in 2014 and 4.2% in 2015. Such possibilities would signify considerable improvement in the demand for raw materials and, in particular, demand for products such as steel and the main nonferrous metals.

From the perspective of the raw material markets, an acceleration in global output growth is an important precondition for stronger offtake growth and, eventually, better prices. Accelerating growth usually brings with it a pickup in investment spending and a boost to raw material purchases as production runs ahead of demand in anticipation of improving conditions and business displays a newfound willingness to build inventories.

Changes in the momentum of growth, rather than the growth rates themselves, are most likely to provide the leading signs of improved conditions in the real economy. Similarly, financial and derivative markets also distinguish between speed and acceleration, responding positively to the latter as investors seek to anticipate how other investors will be reacting.

A prospective acceleration in growth of the magnitude being forecast would normally imply markets are poised to raise the prices of securities leveraged to these conditions. Unfortunately, there has been too much disappointment for investors to readily embrace such possibilities, no matter how analytically well-based they might appear.

Growth has been running at 3-4% for most of the last three years but, in each case, the result has been tinged with disappointment leading investors to become unusually preoccupied with the downside risks. In the case of the IMF, for example a 4% start for each forecast year since 2010 has trailed off to something closer to 3% by the end.

Having to continually revise down the immediate future undermines confidence about the longer term outcomes and keeps market mindsets anchored in the relatively pessimistic phase of the cycle. That said, the flow of statistics does suggest that momentum is moving slowly in the right direction. The stabilisation of the growth rate upon which an acceleration can be built is becoming evident.

Against this background, an emerging scenario for the coming few months is one in which there will be little change to resource sector prices while a cyclical bottom in market values is being more clearly defined.

Considerable day to day volatility might be evident (as in late 2009-early 2010 and, again, in late 2008-early 2009) before any material change in direction occurs.
By December, when there might be greater confidence about the momentum of economic activity, cyclical and seasonal effects could combine to generate enough firepower to escape what will, by then, have been a three year performance straightjacket.

Not coincidently, earlier cycles have also gained momentum with the help of the late December seasonal effect referred to in my 3 July 'From the Capital' column.

Consequently, for the present, the market remains awkwardly poised, consistent with both a cyclical move up in the coming months as well as a continuation of a long term downward re-pricing of the sector to reflect not only cyclical but also structural changes. The market appears positioned around a point of inflection.

Since the balance of the available macroeconomic data is signaling a tendency toward stability, it makes sense for the time being to stick to the idea of a late 2013 improvement in market conditions.

There will typically come a point in this scenario where those stocks most heavily leveraged to an improvement in economic conditions will display outstanding share price performance partly, it must be said, because the new starting point is just a fraction of what their prices had once been.

Given the anticipatory nature of equity markets, several cyclical upturns are usually anticipated for every one that eventuates. Particularly in the trough of a cycle, examples of leveraged plays experiencing unsustainable share price gains will tend to proliferate as investors begin to get a hint of an improvement in market conditions and begin searching for the securities best able to elicit large investment returns.

On firmer ground, the sort of conditions that might prevail by the end of 2013 and into 2014 should help support those companies that have successfully developed, or are close to finalising, new projects. While they have often been bashed about as much as even some of their poorly managed peers, some relief for them might be in sight.

From a portfolio perspective, it would make sense to retain a significant amount of cash while awaiting clearer evidence of the momentum change referred to above.

Beyond the end of 2013, the metaphorical tidal rise that lifts all boats will depend on a further acceleration in global growth. At least one year of 5%-plus global growth will almost certainly be needed to help soak up inventories and the continuing growth in metal supplies as a pre-requisite to another cyclical upturn. At this stage, no-one is game enough to put that on the table as anything more than a risk to a more muted base case.

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